The Least Explicable Bubble Of All

Of all the mini-bubbles now inflating out there, maybe the least explicable is the race among emerging market companies to borrow dollars. This has gotten them – and their governments — in huge trouble so many times in the past (see the Mexican default of 1982 and the the Asian contagion of 1997) that you’d think dollar debt would be kind of a hot stove thing for Brazilians and Mexicans.

(Bloomberg) – Emerging-market companies are showing up to the U.S. debt market at the fastest pace ever, and finding plenty of appetite for their bonds.

Sales of dollar-denominated notes have climbed to about $160 billion this year, more than double offerings at this point in 2016 and the fastest annual start on record, according to data compiled by Bloomberg going back to 1999. Emerging-market assets tanked after Donald Trump’s surprise election in November, but they’ve quickly recovered, with bonds returning 4 percent this year and outperforming U.S. investment-grade and high-yield debt.

The deluge of issuance began when companies anticipating a surge in borrowing costs amid economic stimulus from Trump rushed to sell notes before his inauguration Jan. 20. But the expected jump never materialized, extending the window for companies like Petroleo Brasileiro SA and Petroleos Mexicanos to pursue multi-billion-dollar deals. They found plenty of demand from investors keen to buy shorter-dated debt that’s better insulated against rising U.S. interest rates.

Jean-Dominique Butikofer, the head of emerging markets for fixed income at Voya Investment Management in Atlanta, said he’s seen new interest in emerging markets from investors who already own U.S. high-yield bonds or emerging market sovereign debt that’s more vulnerable to rising interest rates.

“You want to be less sensitive to U.S. rates, but you still want to diversify and you still want to play the EM catch-up growth story,” said Butikofer, whose firm manages $217 billion. “You’re going to gradually add emerging-market corporates.”

The investable universe for emerging-market corporate debt is small, but growing quickly, with about $426 billion outstanding, according to Bloomberg Barclays Index data. That’s less than a tenth of the size of the U.S. investment-grade credit market. The notes have an average maturity of 6.3 years, compared with 10.8 years for investment-grade debt.

Economic Shift

Developing nations now rely less on exporting their goods to the U.S. and more on local consumption than in previous says, said Samy Muaddi, a Baltimore-based money manager at T. Rowe Price Group Inc., which oversees $862 billion.

“The EM growth model has really shifted in the last 10 to 20 years,” Muaddi said. “Consumption has risen as a share of GDP in many of the countries we’re involved in. That growth driver is pretty durable irrespective of U.S. policy.”

Debt from Indonesia, Argentina and Brazil is particularly attractive as those countries implement economic reforms, Muaddi said. While Trump’s trade policies may be bad news for Mexican companies if he scraps the North American Free Trade Agreement, he said many of the world’s biggest geopolitical risks are in developed markets — think Britain’s negotiations to leave the European Union or France’s election outcome. That’s upending the usual dynamic in which emerging markets are considered less stable.

Risks still remain. A surge in the greenback could spell bad news for emerging-market companies with lots of dollar debt and revenue mostly in a local currency. The overseas debt binge has boosted their total foreign corporate debt due in the next five years to $1.58 trillion, according to the Institute of International Finance. About 80 percent of that is dollar denominated.

‘Original Sin’

That could cause problems, according to Ricardo Hausmann, the director of the Center for International Development at Harvard University in Cambridge, Massachusetts.

While developing nations and their companies aren’t as dependent on overseas debt as they were in the 1980s — when a similar pattern sparked a wave of defaults in Latin America — a rising dollar “will make it that much harder for companies and sovereigns with ‘original sin’ to pay,” Hausmann said. He coined the term in reference to developing countries’ reliance on overseas debt in an article for Foreign Policy magazine almost two decades ago.

Investors seem unconcerned. They’ve poured $1.9 billion into mutual funds that purchase emerging-market debt denominated in dollars and other major currencies, according to data provider EPFR Global. The few exchange-traded funds that buy up the bonds have also had inflows of more than $200 million, Bloomberg data show.

“There has been a lot of supply, but it’s been absorbed very well by the market,” said Daniel Senecal, a credit analyst at Newfleet Asset Management in Hartford, Connecticut, which manages $12 billion.

So…emerging market debt is a great way to diversify because these countries are no longer export-dependent, thus “insulating” them from the risk of rising US interest rates. Furthermore, the developed world is where all the geopolitical risk now resides, so Brazil, Mexico (and Indonesia and Argentina!) have become safe havens.

If this seems to stretch the bounds of credulity, that’s because peak bubble rationales always do. In 1999 tech company earnings were “optional” and eyeballs were all that mattered. In 2006 home prices always went up so any price was a good price.

With today’s multiple bubbles such nonsense is everywhere. A college degree is worth millions over a lifetime so at a borrowed quarter-mil it’s a bargain. Modern cars will last decades so a 7-year auto mortgage is the best way to buy – especially if you have bad credit. Trump’s tax cuts will boost corporate profits without unduly increasing the deficit, so stocks at historically-high valuations are actually cheap.

But again, the craziest rationale has to be that since Latin American economies are now driven by local consumers, dollar-denominated debt is the best way for an Argentine copper miner to finance its expansion.

Here’s a quick scenario to ponder: The US blunders into another Middle-East war (or a stock market crash or unexpected slowdown when the auto, housing and student loan bubbles burst simultaneously) sending terrified capital pouring into Treasury bonds and pushing up the dollar.

That cheap emerging market dollar-denominated debt becomes 30% – 50% more expensive, causing a wave of borrowers to implode. And once again shell-shocked buyers of insanely-overvalued assets look back on their delusions and wonder what they were thinking.